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Wednesday, May 21, 2014

What to do about the Impending Stock Market Crash

A stock market crash of 20% or more is coming. We all know it. Of course, it might not happen until the stock market triples first. So what do we do about it? It’s hard to believe that the right thing to do is nothing at all.

From 2008 June 18 to 2009 March 9, the S&P/TSX Composite Index of Canadian stocks dropped by almost 50% (counting dividends). By simply selling at the beginning of this period and buying back at the end, anyone could have doubled the number of shares he or she owned. A market timer could have beaten a buy-and-hold strategy by almost 100%!

All the available evidence says that nobody can reliably predict the beginning or end of a stock market crash. The problem with guessing wrong is that you’re left on the sidelines watching stock prices rise without you. All available evidence says that you should stick with a good investment plan and just ride out stock market crashes.

I’ve known people who accept that the most profitable long-term plan is to ignore the possibility of stock market crashes. Yet they still pay attention to confident talking heads on television who offer meaningless predictions about stock prices.

More baffling to me is exchanges I have with people that go something like the following:

Investor: “Do you think stocks are overvalued? Is it time to get out?”

Me: “I have no useful insight into the near-term future of stock prices. I don’t believe anyone else does either.”

Investor: “Yes, I know that. But what do you think will happen? Maybe interest rates will go up soon?”

This ability for otherwise intelligent people to believe completely contradictory ideas is strange.

In any case, I’ve cast my lot with an investment strategy that makes no attempt to predict stock market crashes at all. I believe I’m on the side of the evidence, but I don’t expect this position to become very crowded with typical investors.

11 comments:

Interesting article, but you're implicitly arguing that holding cash is the wrong thing to do. The framework of the argument reminded me of this quote from Seth Klarman (>20% annualized over 27 years), writing in 2004:http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Seth%20Klarman/Seth%2520Klarman%2520on%2520Cash.pdf

Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn’t a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can’t or won’t say no forgoes perhaps the most valuable tool available to investors. Charlie Munger, Warren Buffett’s long-time partner, has counseled investors, “Look for more value in terms of discounted future cash flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.”

It's a healthy portfolio discipline to hold some cash except when index prices are lowest -- i.e., blood in the streets. Indexers have a herding mentality which leads them to buy more index shares even as the index pricing exceeds business value. Holding cash today when index prices are high means that the same cash is available in the future when index prices are low. Then the cash that was preserved can be put to work at above average rates of return while the herd runs away from the market. The best time to invest is during that "sickening plunge" in the index while it is "on sale" and the odds are in your favor as Klarman and Warren Buffett's partner Charlie Munger point out.

James Montier has some great charts on the value of cash in a portfolio:http://trendfollowing.com/whitepaper/JM_TailRisk_611.pdf

@Anonymous: Holding cash in my portfolio is of no use to me. I would have to be sufficiently good at identifying under-priced stocks or indexes to overcome the opportunity cost of holding cash. The typical investor can't do this either.

A quality index behaves differently from an individual value stock. If your practice is to invest in companies that are under a serious threat of bankruptcy in the near future, then caution and a default choice to say no are warranted. But if those stocks behaved in the exact same way as the index, why would anyone be a value investor?

@Michael James: I guess that your default answer is no to Klarman's question.

You're an engineer, so I'll throw a good engineering problem solving technique at you - invert the problem. There is also the opportunity cost of NOT holding cash which you've convinced yourself doesn't exist. This is really the key plank to some of the most successful investors' results.

I'd love to see you write about the opportunity cost of not holding cash. Having cash available allows one to take advantage of opportunity and makes a portfolio resilient rather than fragile. Cash in a downturn equals opportunity. When you say that you aren't sufficiently good at identifying under-priced indexes, were you not around in 1973, 1980, 1987, 1990, 1998, 2001, 2008? The headlines were ablaze with fear-mongering, doom, and gloom. It's not that hard, but perhaps I'm just wired differently to raise cash in good times and have the courage to invest available cash when things look crappy. Perhaps it's a rare skill?

@Anonymous: I was around (as an investor) for most of the years you listed. If you correctly identified those years as good times to deploy cash and possibly even borrow to invest, your returns would be staggering. Since I don't know who you are and likely don't know you personally, I can't comment on your skills. However, when I talk to some people who I did know through the 2008-2009 crash and they claim now that it was obviously a great time to invest, I can remember that they were as scared as everyone else at the time. They suffer from hindsight bias that makes them think they knew it all along when they didn't.

Torn on this subject. I get that short-term market timing is a fool's game. But I do think there is an important distinction to be made between that and paying heed to measures that actually correlate with more long-term prospective returns. Big fan of John Hussman's work so I would encourage folks to read one of his recent commentaries that speaks to this (http://www.hussmanfunds.com/wmc/wmc140512.htm). The future remains unknowable, but I find Mr. Hussman's work, along with that of James Montier and Jeremy Grantham at GMO, pretty darn persuasive. I'm not out of equities but I certainly feel like holding a sizeable position in cash and short bonds, and reducing exposure to US equities in particular, isn't the worst plan at the moment either. Hopefully balance and diversification will see me through.

@Juan: I have no doubt that there is some upside to paying attention to valuations. However, there is a downside too. The opportunity cost of being out of equities while they continue to appreciate faster than other types of investments is a real cost. So, it isn't good enough to have just a small amount of useful insight into valuations; you must have enough useful insight to overcome the opportunity cost. I've made my decision that I don't expect to come out ahead playing the valuation game. Other investors may come to different conclusions.

The idea sounds good, but when I compare them I'll take the option that involves nearly no work, much less risk of being wrong, and still has excellent historical results. That means being fully invested all the time. A cornerstone of good investing is avoiding unnecessary risks and I know I will have more than enough from following this approach.